Wednesday, 30 March 2011


I think the IMF is trying to give Ireland a hint. Or perhaps Greece. Or maybe their staff have too much time on their hands.

Remember about a month ago when I wrote about the effects of the 'investment-grade' premium on our spreads? The idea back then was that regaining the investment-grade glamour would push our spreads back down to barely-viable levels, although of course this was never going to happen.

More dedicated readers might also remember this analysis which I did a propos the Stiglitz "Leave Britney Greece alone!" article in the Guardian. (Readers less up to date with the cultural reference will probably have to read this).

As these readers will recall, I believe that the Stiglitz intervention marked the end of our sovereign period by rallying Greek pundits around the idea of a 'mild adjustment' and thus convincing the rest of the world that we were never going to get serious about the debt situation. Thanks MUPPET. I'll send you the bill in spilt guts.

Well this argument has now been made far more formally by the IMF's researchers, in a recently published analysis of what is called 'debt dilution'. Debt dilution basically works like this: if Greece owes say 100% of GDP and is running a huge deficit, a new creditor knows that the chances of being paid, let alone being paid out first, are diluted by the fact that there's going to be a long, growing queue of people waiting to be paid too, some of them our own citizens, and some nominally senior creditors like the IMF and the EU.

The authors simulate what would happen if we were to throw in a guarantee to compensate bondholders for any losses they suffer as a result of our bonds losing value due to dilution. This will of course never happen but it helps isolate the effects of dilution.

It turns out that, for the average sovereign, dilution accounts for 36% of the amount of nominal debt issued (because undilutable debt would be issued at better prices/lower yields) and an amazing 92% of the average spread. Let me put this another way. This would mean that Greece would pay an amazing 4.21% on its debt based on these spread figures. Btw the implied 74bp spread is not entirely fictitious; it is actually more than what we used to pay between 2002 and 2007 (although note these are spreads v. bunds, not T-bills as in the calculation above).

This should really serve to remind people of how stupid investors were back in those days. But it should also explain just why the balance in favour of default can tip so quickly. In our present state, where investors know not only that their chances of getting paid decrease with each penny we borrow but also that we would be genuinely better off defaulting, is it any surprise that the only people buying Greek debt are the ones who have no choice?

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